Conglomerates: 2 reasons I think they should exist.

An interesting idea popped up in my head while I was discussing Conglomerates in my syndicate today. Conglomerates are, in the most basic sense, a corporate that follows un-related diversification of businesses. Like portfolio management, the idea is to buy and hold the businesses to minimize risk. In our corporate strategy class, we discussed Textron Corporation, a very successful conglomerate that provided superior returns to its investors. The key insight of the case study was, that the need for the conglomerate arose because of the lack of efficient markets. Lack of debt markets for small firms, lack of management skills, lack of efficient capital markets due to high degree of information asymmetry. All of this meant, the corporate was able to centrally provision resources to the businesses and add value.

Cool. But we were also told that in the western world, as markets became more efficient, management training more prevalent and information asymmetry solved, the need for a conglomerate has been eroded. The value-add is lower, in fact, the individual businesses may do better outside the conglomerate as they would be better understood and if customers can diversify themselves by picking stocks, then why should the corporate office do this? 

Now… if the markets know this, then this leads to the idea of the conglomerate discount, where a conglomerate share price is discounted due to the perceived ‘burden’ of the corporate office.

But, sitting with my syndicate, hashing out why a firm we were analysing had diversified, I reasoned that maybe some businesses lend themselves better to a conglomerate structure. I refer to military or high technology manufacturing industries like aerospace and aircraft engines. G.E. and UTC are the examples I want to consider. Both G.E and UTC are conglomerates and both own businesses of aircraft engines and military hardware/helicopters etc. The conglomerate structure in these firms exists, I believe because of the nature of these businesses.

There is far too much risk in being Pratt and Whitney. P&W has experienced huge setbacks in the past when the DOD closed projects etc. Would it have survived without the conglomerate? If these businesses that serve aviation, an industry that may have severe downturns existed independently, they may end up crashing & burning, filing for bankruptcy and in need of a bailout. Rationale then for these businesses to pursue diversification is to ensure that in the bad times, the industry does not collapse.

A second reason is, these industries have niche talent requirements and high R&D costs with a need for strong relationships with suppliers. (Vertical Integration is out of the question if you want to be nimble in R&D and adopting new technologies, so you essentially source parts from external suppliers because you accept you cant do everything in the best way yourself. Yes, you can make the best quality radar, but no you cant make the best possible database) But if relationships with suppliers is important, then in an industry downturn, will those suppliers want to deal with you? Well YES if you are UTC or GE. They may think twice if you are just the single business as they worry you may not be around in a few months…

So that’s my 2 cents on why Conglomerates still have a place.

Of course I wont be asking my professor to validate this, because I’m now officially frightened of him. He recently SHOUTED at me in class for a misunderstanding. 😦

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